HAPTER - 2 THEORY BASE OF ACCOUNTING Weightage : 6 Marks 1 Basic Accounting Assumptions 2 Basis Principles of Accounting _3 Accounting Conventions Basic Accounting Assumptions The Accounting Entity Assumption. This concept assumes that the business is an en- tity distinct and separate from its owners. All business transactions are recorded in the ‘books of the business from the point of view of the business and not from the point of view of the proprietor. Even the proprietor is treated as a creditor to the extent of his capital Therefore, the firm allows interest on capital employed by the proprietor. For example, If Mr. Ram starts business with Rs. 10,000 in cash, then Mr, Ram will be a creditor of the firm to the extent of capital invested by him in the business and such amount will be credited to his capital account. Similarly when he withdraws some money and goods for his per- sonal use it will be debited to his personal account. ti.e., Capital Account. The Going Concern Assumption. According to this assumption the business will last for tong time and accounting is done from this point of view. ?tis assumed that the business enterprise has neither the intention nor:the necessity to wind up its business or to curtail the scale-of its operation substantially. It is on the basis of this concept that the cost of fixed assets is allocated over thej'useful life. The recording and valuation of assets is based on this assumption. This concept is the backbone of accounting system. T h e following points explain the importance of this concept : (a) Fixed Assets are valued at cost less Depreciation (b) Prepaid Expenses are shown as an asset in the Balance Sheet (©) Depreciation on assets is charged on the basis of their expected life and no attention is given to their current values The Accounting Period Assumption. According to this assumption the firm's life cycle is divided into accounting periods, such periods are called-accounting year, €.9., 1 year. 6months, etc. Since the business life is assumed to be indefinite as per going concer concept, therefore, it is not possible for a business man to wait for measurement of in- come at the end of the life of business. That's why, the entire life of the business is divided into smaller time intervals and each time-interval is of 12 months which is known as Accounting Period. This accounting periodlyear can be of 2 types, viz., (@) Calender year (From 1st Jan.-31st Dec.). (b) Financial year (from 1st Aprit- 31st March).fic ic coteoriate 4 iy? Basi wi == 1 2. ‘The Money Measurement Assumption. Only those transactions and events are recorded which can be measured in terms of money. It means those events or transactions which are of non-monetary nature, do not find any place in the books of accounts, howsoever, important they may be e.g. Employer - Employee relationship, Quality of the product, calibre of the workers and management, working conditions; etc. One of the limitation of this concept is that a transaction is recorded at its monetary value, the date of eccurrence and the subsequent changes in the price level are ignored. Dual Aspect Principle. tt states’ that each transaction has two aspect. viz, debit and credit Double Entry System is based on these two aspects. Debit represents addition to or creation of new assets, increase in an expense and reduction or élimimution, of a Liability. (On the other hand, Credit means Creation of orladdition to Liability or an income. At any point of time, the value of Total assets of a business must be eqdial to'the value of Liabili- ties towards outsiders and owners, which is called Capital.in equation form, it would mean. Assets = Capital + Liabilities The system of accounting which is based on this dual aspect is called “Double Entry ‘System of Book - Keeping.” Verifiable Objective Evidence. All transactions which are recorded in the books of ac- ‘counts must be supported by vouchers verified-by the Auditor. It implies that all account- ing transactions should be supported by objective documents. These documents include invoices, contracts, vouchers, bills, Pass Books, etc. Personal bias has no place in prepa- ration and presentation of financial records whether they are books of accounts or finan- cial statements, Revenue Recognition Realisation Principle. According'to this, revenue is realised/ recognised to have been eamed as soon as the sale of goods or rendering of service is ‘completed. itis immaterial whether the price or reward is received immediately or will be received in future. It means the revenue is realized when the title of goods passes from the seller to the buyer or when the services are rendered to the customer. Exception to this rule : ‘ (@) Inthe case of gold or diamond mining, revenue is recognised even much before the actual sale takes place since these things have definite value. (©) _ Incase of fixed price specific contract of construction, reventieis recognised much before the contraicts are actually:completed. et Historical Cost Concept. According to this concept, all assets acquired are recorded at a price paid at the time of their purchase. Any change in the value of these assets due to ‘change in. the price level (inflation or deflation) is not considered:or recorded. This is called historical cost. Historical cost is most objective; reliable, definite and is also free from all personal bias. 2 E < Limitations of Historical Concept: tee (a) Fails to present a true financial position of the business entity during inflationary periods, F (©) Financial Statements of two firms prepared at two different points of time may not be really comparable because both the firms had acquired the similar assets at different prices Matching Principle. According to this principle, the expenses incurred ian accounting year should be matched with the revenue recognised in that period so as to give the true view of the profitability of an organisation. The matching principle is applied by determin ing the revenue and releted expense to the accounting period.For example : if goods costing Rs. 1500 are sold for Rs. 2,000 and it is reasonably certain that revenue will be realised, then Rs. 1.500 cost of sales is matched with revenue to give the net resutt of Rs. 500 as profit. This principle is directly associated with the concept of realisation and accrual. 6. Principle of Full Disclosure. This principle states that financial statements and accom- panying notes should, contain full disclosure of all significant financial information. Discto- sure should be full and fair and adequate and make the financial statements useful and not misleading. The financial statements are prepared for the benefit of inside and outside users like owners, investors, creditors, bankers, etc. Therefore, these statements should be honestly prepared, free from any bias, favour or prejudice, Figures should not be manipu- lated. This principle is in keeping with the latest trend that financial statements are a means of conveying and not concealing the information, For example, while reporting sales during the year, sales retum should be shown sepa- rately and deducted from the amount of Sales, rather than showing the net sales for the year. As the huge sales retum can raise the inquiry and may lead to corrective action. Similarly, itis necessary that all significant accounting policies adopted in the preparation of financial statements should be disclosed, ¢.g., change in the adoption of Depreciation Method. 7. Accrual Concept. According to this concept, all expenses and revenues are recorded on the basis of their occurrence and not on the basis of actual cash paid or received. There will be a profit when current year revenue exceeds the current year expenses and the capital increases. There will be a foss when the current year expenses exceeds the our- rent year revenue and it reduces the capital 2 Accounting Conventions Materiality. This concept is a modifying principle and is an exception to the principle of full disclosure. This principle states that only those items are to be disclosed in the financial statements which are material or important for decision making by those people who may be interested in the financial position of the business. ‘An information is considered to be material if this would have changed the results of the business, if it would have been disclosed. Similarly, an item is considered to be material or important if this would have changed the decision of the person to whom this information is communicated. Materiality of an item is judged on the basis of. (a) Materialty of Information (b) Materiality of Amount. 2. Convention of Consistency. Aécording to this Convention the bases of preparing ac- ‘counts should be consistent and should not be altered over a short period of time. In other words, to compare the results of a business unit for different periods, itis necessary that the policies and procedures adopted in one year are followed year after year. In certain cases, it is possible to. adopt more than. one method of treating an item. For example, depreciation maybe charged by straight line method or by Diminishing Balance Method. But same method should be adopted for different accounting periods, It does not mean that the method cannot be changed but whenever it is changed, the fact should be stated in the financial statements. If this principle is not adopted, different results can be drawn from the same accounting data. Similarly, the policies of valuation of closing stock, provi sion for bad debts should remain same year after year and if they are changed, the fact should be disclosed in the financial statements.